Finance 325- Exam 1
Perpetuity
An annuity in which the cash flows continue forever
What best illustrates that the management of a firm is adhering to the goal of financial management?
An increase in the market value per share
Free cash flow
Another name for cash flow from assets
Suppose you invest $500 today, $1000 at the end of one year, $2000 at the end of the second year, and $3000 at the end of the third year. If your investment pays 6% interest per year, how much will you have at the end of four years?
=500*(1.06)^4+1000*(1.06)^3+2000*(1.06)^2+3000*1.06 = $7,249.45
Standardized Industrial Classification (SIC) code
A U.S. government code used to classify a firm by its type of business operations
Corporation
A business created as a distinct legal entity and treated as a legal "person"
Corporation
A business created as a distinct legal entity composed of one or more individuals or entities
Partnership
A business formed by two or more individuals or entities
Sole proprietorship
A business owned by a single individual
Uses of cash
A firm's activities in which cash is spent. Also called applications of cash
Sources of cash
A firm's activities that generate cash
Statement of cash flow
A firm's financial statement that summarizes its sources and uses of cash over a specified period
Cash flow to creditors
A firm's interest payments to creditors less net new borrowing
Annuity
A level stream of cash flows for a fixed period of time
Common-size statement
A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage sales
Common-base year statement
A standardized financial statement presenting all items relative to a certain base year amount
Consol
A type of perpetuity
Marginal tax rate
Amount of tax payable on the next dollar earned
Discount
Calculate the present value of some future amount
Discounted cash flow (DCF) valuation
Calculating the present value of a future cash flow to determine its value today
The process of planning and managing a firm's long-term investments
Capital budgeting
The mixture of debt and equity maintained by a firm
Capital structure
The 2017 balance sheet of Kerber's Tennis Shop, Inc., showed long-term debt of $6.1 million, and the 2018 balance sheet showed long-term debt of $6.3 million. The 2018 income statement showed an interest expense of $210,000. During 2018, the company had a cash flow to creditors of $10,000 and the cash flow to stockholders for the year was $65,000. Suppose you also know that the firm's net capital spending for 2018 was $1,460,000, and that the firm reduced its net working capital investment by $87,000. What was the firm's 2018 operating cash flow, or OCF?
Cash flow from assets = Cash flow to creditors + Cash flow to stockholders Cash flow from assets = $10,000 + 65,000 Cash flow from assets = $75,000 Cash flow from assets = $75,000 = OCF - Change in NWC - Net capital spending Cash flow from assets = $75,000 = OCF - (-$87,000) - 1,460,000 Operating cash flow = $75,000 - 87,000 + 1,460,000 Operating cash flow = $1,448,000
The 2017 balance sheet of Kerber's Tennis Shop, Inc., showed long-term debt of $6.5 million, and the 2018 balance sheet showed long-term debt of $6.9 million. The 2018 income statement showed an interest expense of $185,000. What was the firm's cash flow to creditors during 2018?
Cash flow to creditors = Interest paid - Net new borrowing Cash flow to creditors = Interest paid - (LTDend - LTDbeg) Cash flow to creditors = $185,000 - ($6,900,000 - 6,500,000) Cash flow to creditors = -$215,000
Cashflows to creditors
Cash flow to creditors= interest paid- net new borrowing
The 2017 balance sheet of Kerber's Tennis Shop, Inc., showed $470,000 in the common stock account and $4.5 million in the additional paid-in surplus account. The 2018 balance sheet showed $510,000 and $4.8 million in the same two accounts, respectively. If the company paid out $420,000 in cash dividends during 2018, what was the cash flow to stockholders for the year?
Cash flow to stockholders = Dividends paid - Net new equity Cash flow to stockholders = Dividends paid - [(Commonend + APISend) - (Common beg + APIS beg)] Cash flow to stockholders = $420,000 - [($510,000 + 4,800,000) - ($470,000 + 4,500,000)] Cash flow to stockholders = $80,000 Note, APIS is the additional paid-in surplus.
Cashflow to stockholders
Cash flow to stockholders= dividends paid- net new equity raised
Operating cash flow
Cash generated from a firm's normal business activities
The 2017 balance sheet of Dream, Inc., showed current assets of $2,960 and current liabilities of $1,225. The 2018 balance sheet showed current assets of $3,300 and current liabilities of $1,720. What was the company's 2018 change in net working capital, or NWC?
Change in NWC = NWCend - NWCbeg Change in NWC = (CAend - CLend) - (CAbeg - CLbeg) Change in NWC = ($3,300 - 1,720) - ($2,960 - 1,225) Change in NWC = $1,580 - 1,735 Change in NWC = -$155
Net working capital
Current assets less current liabilities
Cash flow to stockholders
Dividends paid out by a firm less net new equity raised
Suppose you plan to invest $500 in a CD at the end of every year for 4 years. The CD pays 5% per year. How much will you have accumulated at the end of the 4 years? FVannuity = C x [(1+r)t - 1]/r
FV = $2,155.06
Suppose you invest $2,000 in ABC stock today. ABC stock does not pay any dividends, but you expect to earn an annual return of 7% per year. What will be the value of your investment in 8 years? PV= I/Y= N= FV=
FV = $2633.62
Suppose GM Corporation promises to pay all its employees a bonus of $100 in 2 years. GM has about 173,000 employees. What is the present value of that obligation, assuming an appropriate discount rate of 5% per year? FV= I/Y= N= PV=
FV of obligation = 173,000*100 = 17,300,000 PV = $15,691,609.98
If you deposit $4,000 today in an account paying 11% per year. How much will you have in 5 years?
FVt = PV * (1 + r)t so FV5 = $4,000 * (1+.11)5 FV5 = Using TVM: PV = -4000 , r(I/Y) = .11 , t(N) = 5 FV = $?
Balance sheet
Financial statement showing a firm's accounting value on a particular date
Income statement
Financial statement summarizing a firm's performance over a period of time
What action by a financial manager is most apt to create an agency problem?
Increasing current profits when doing so lowers the value of the company's equity
Sarbanes-Oxley
Intended to protect investors from corporate abuse
Compound interest
Interest earned on both the initial principal and the interest reinvested from prior periods
Interest on interest
Interest earned on the reinvestment of previous interest payments
Simple interest
Interest earned only on the original principal amount invested
Griffin's Goat Farm, Inc., has sales of $677,000, costs of $339,000, depreciation expense of $83,000, interest expense of $51,500, and a tax rate of 25 percent. What is the net income for this firm?
Sales $677,000 Costs -$339,000 Depreciation -$83,000 EBIT =$255,000 Interest -$51,500 EBT =$203,500 Taxes (25%) -$50,875 Net income =$152,625
The King Corporation has ending inventory of $481,040, and cost of goods sold for the year just ended was $4,642,036. a.What is the inventory turnover? b.What is the days' sales in inventory? c.How long on average did a unit of inventory sit on the shelf before it was sold?
Inventory turnover = COGS/Inventory Inventory turnover = $4,642,036/$481,040 Inventory turnover = 9.65 times Days' sales in inventory = 365 days/Inventory turnover Days' sales in inventory = 365/9.65 Days' sales in inventory = 37.82 days On average, a unit of inventory sat on the shelf 37.82 days before it was sold
Which one of the following best states the primary goal of financial management?
Maximize the current value per share
Suppose we invest $5,000 in a security earning 8% per year. Determine how many years it will take for the investment to be worth $10,000. FV= I/Y= N= PV=
N = 9.01 years
Suppose you have $2000. You would like to buy a new mountain bike, but the bike you have in mind costs $3500. If you can earn 6% per year, how long until you can afford the bike you want? FV= I/Y= N= PV=
N = 9.6 years
Logano Driving School's 2017 balance sheet showed net fixed assets of $3.8 million, and the 2018 balance sheet showed net fixed assets of $4.1 million. The company's 2018 income statement showed a depreciation expense of $415,000. What was net capital spending for 2018?
Net capital spending = NFAend - NFAbeg + Depreciation Net capital spending = $4,100,000 - 3,800,000 + 415,000 Net capital spending = $715,000
Limited partnership
One or more general partners will run the business and have unlimited liability
Suppose you are considering an investment that will pay you $1000 a year for three years. Your required return on this investment is 8% per year. How much would you be willing to pay for this investment?
PV = $1000 [1-[1/(1+.08)3]]/.08 = $1000 [1-0.7938]/.08 = $1000 [0.2062] / .08 = $2577.10
Suppose you need $25,000 in 4 years for a down payment on a house. If you can earn 7.5% on your money, how much do you need today? FV= I/Y= N= PV=
PV = $21,576.83
Suppose we have an investment opportunity that promises to pay us $500 at the end of one year, $1000 at the end of two years, and $1500 at the end of three years. If our discount rate is 12% per year, what is the present value of this investment opportunity? PV =$500/(1+.12)1 + $1000/(1+.12)2 + $1500/(1+.12)3 PV=
PV = $2311.29
What is the present value of $500 to be received in 10 years? Assume the appropriate discount rate is 3%. FV= I/Y= N= PV=
PV = $372.05
If Roten Rooters, Inc., has an equity multiplier of 1.52, total asset turnover of 1.20, and a profit margin of 6.2 percent, what is its ROE?
ROE = (PM)(TAT)(EM) ROE = (.062)(1.20)(1.52) ROE = .1131, or 11.31%
Twist Corp. has a current accounts receivable balance of $348,800. Credit sales for the year just ended were $4,482,080. a. What is the company's receivables turnover? b. What is the company's days' sales in receivables? c. How long did it take on average for credit customers to pay off their accounts during the past year?
Receivables turnover = Sales/Receivables Receivables turnover = $4,482,080/$348,800 Receivables turnover = 12.85 times Days' sales in receivables = 365 days/Receivables turnover Days' sales in receivables = 365/12.85 Days' sales in receivables = 28.40 days On average, the company's customers paid off their accounts in 28.40 days.
Liquidity
Refers to the speed and ease with which an asset can be converted to cash
Financial ratios
Relationships determined from a firm's financial information and used for comparison purpose
What is a primary market transaction?
Sale of a new share of stock to an individual investor
Pompeii, Inc., has sales of $51,000, costs of $23,400, depreciation expense of $2,350, and interest expense of $2,100. If the tax rate is 25 percent, what is the operating cash flow, or OCF?
Sales $51,000 Costs -$23,400 Depreciation -$2,350 EBIT =$25,250 Interest -$2,100 Taxable income =$23,150 Taxes (25%) -$5,788 Net income =$17,363 OCF = EBIT + Depreciation - Taxes OCF = $25,250 + 2,350 - 5,788 OCF = $21,813
Griffin's Goat Farm, Inc., has sales of $675,000, costs of $337,000, depreciation expense of $81,000, interest expense of $50,500, a tax rate of 23 percent, and paid out $42,500 in cash dividends. What is the addition to retained earnings?
Sales $675,000 Costs -$337,000 Depreciation -$81,000 EBIT =$257,000 Interest -$50,500 EBT =$206,500 Taxes (23%) -$47,495 Net income =$159,005 One equation for net income is: Net income = Dividends + Addition to retained earnings Rearranging, we get: Addition to retained earnings = Net income - Dividends Addition to retained earnings = $159,005 - 42,500 Addition to retained earnings = $116,505
Which one of the following is a working capital management decision?
Should the firm pay cash for a purchase or use the credit offered by the supplier
Stakeholder
Someone other than a stockholder or creditor who potentially has claim on the cash flow of the firm
Retention ratio
The addition to retained earnings divided by net income. Also called the plowback ratio
Future value (FV)
The amount an investment is worth after one or more periods
Heritage, Inc., had a cost of goods sold of $44,121. At the end of the year, the accounts payable balance was $8,143. How long on average did it take the company to pay off its suppliers during the year?
The average time to pay suppliers is the days' sales in payables, so: Payables turnover = COGS/Accounts payable Payables turnover = $44,121/$8,143 Payables turnover = 5.42 times Days' sales in payables = 365 days/Payables turnover Days' sales in payables = 365/5.42 Days' sales in payables = 67.36 days
Cash flow identity
The cash flow from a firm's asset is equal to the cash flow paid to suppliers of capital to the firm
Generally Accepted Accounting Principles (GAAP)
The common set of standards and procedures by which audited financial statements are prepared
Present Value (PV)
The current value of future cash flows discounted at the appropriate discount rate
Cash flow
The difference between the number of dollars that came in and the number of dollars that went out
Annual percentage rate (APR)
The interest rate charged per period multiplied by the number of periods per year
Effective annual rate (EAR)
The interest rate expressed as if it were compounded once per year
Stated interest rate
The interest rate expressed in terms of the interest payment made each period. Also known as the quoted interest rate
Agency problem
The possibility of conflict of interest between the stockholders and management of a firm
Compounding
The process of accumulating interest on an investment over time to earn more interest
Discount rate
The rate used to calculate the present value of future cash flows
Cash flow from assets
The total cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash flow, capital spending, and change in net working capital
Queen, Inc., has a total debt ratio of .48. a.What is its debt-equity ratio? b.What is its equity multiplier?
Total debt ratio = .48 = TD/TA Substituting total debt plus total equity for total assets, we get: .48 = TD/(TD + TE) Solving this equation yields: .48(TE) = .52(TD) Debt-equity ratio = TD/TE Debt-equity ratio = .48/.52 Debt-equity ratio = .92 Equity multiplier = 1 + D/E Equity multiplier = 1.92
Average tax rate
Total taxes paid divided by total taxable income
Suppose we want to make equal payments on a five year loan at 10% interest on a principal of $5,000. What size are the cash payments?
Using our PV of an annuity formula: PV = C x [1 - [1/(1 + r)t]]/r $5,000 = C*(1-(1/(1+.10)^5))/.10 $5,000 = C*(1-.621)/.10 $5,000 = C*3.79 C=$1,319.26
SDJ, Inc., has net working capital of $3,020, current liabilities of $4,130, and inventory of $3,780. a.What is the current ratio? b.What is the quick ratio?
Using the formula for NWC, we get: NWC = CA - CL CA = CL + NWC CA = $4,130 + 3,020 CA = $7,150 So, the current ratio is: Current ratio = CA/CL Current ratio = $7,150/$4,130 Current ratio = 1.73 times And the quick ratio is: Quick ratio = (CA − Inventory)/CL Quick ratio = ($7,150 − 3,780)/$4,130 Quick ratio = .82 times
DTO, Inc., has sales of $18 million, total assets of $16.7 million, and total debt of $7.2 million. Assume the profit margin is 5 percent. a.What is the company's net income? b.What is the company's ROA? c.What is the company's ROE?
We need to find net income first. So: Profit margin = Net income/Sales Net income = Profit margin(Sales) Net income = .05($18,000,000) Net income = $900,000 ROA = Net income/TA ROA = $900,000/$16,700,000 ROA = .0539, or 5.39% To find ROE, we need to find total equity. Since TL & OE equals TA: TA = TD + TE TE = TA − TD TE = $16,700,000 − 7,200,000 TE = $9,500,000 ROE = Net income/TE ROE = $900,000/$9,500,000 ROE = .0947, or 9.47%
A firm's short-term assets and liabilities
Working capital
Capital Budgeting
defined as the mixture of a firm's debt and equity financing
Capital Structure
defined as the mixture of a firm's debt and equity financing
Suppose you deposit $5000 today in an account paying r percent per year. If you will get $10,000 in 10 years, what rate of return are you being offered? FV= I/Y= N= PV=
r(I/Y) = 7.18%
Suppose you plan to buy a house in 5 years. You estimate you will need a down payment of $40,000. If you currently have $25,000, what annual rate of interest must you earn to have enough for a down payment? FV= I/Y= N= PV=
r(I/Y) = 9.86%
